The # 1 Way to Reduce Your Taxes

by RJ

in Taxes

The most important question you must ask yourself each year during tax season is, “What tax credits do I qualify for?

There are a lot of mistakes made on income tax returns each year, even when using some of the best
tax software
around. One of the most costly mistakes is not claiming each and every tax credit you’re eligible for.

The purpose of this post is to explain what tax credit are, compare tax credits to tax deductions, and to outline the common tax credits that you may be eligible now or in the future.

What are Tax Credits?

A tax credit is a dollar for dollar reduction in the amount of tax you owe.

For example, if after calculating your tax bill, you find that you owe $2,000, a $2,000 tax credit will reduce your tax bill to zero.

There are two types of tax credits; refundable and non-refundable.

A non-refundable credit can’t reduce the amount of taxes owed passed zero. For example, if you had a $2,000 tax bill and could claim $3,000 in credits, you wouldn’t get a check for $1,000.

Luckily, there are also refundable tax credits. Using the same example above, if you had $3,000 in refundable tax credits, you would get a check back from the U.S. Government for $1,000.

Tax Credits vs. Tax Deductions

To see the difference between a tax deduction v. tax credit, it’s best to use an example.

Say you made $40,000 in 2010. Now, say you’re eligible for the standard deduction, which is $5,700 in 2010. This $5,700 reduction, reduces you’re taxable income to $34,300.

Once you know your taxable income, you then calculate how much tax you owe.

The wrong way to do this is to look at the federal income tax brackets for the year, realize that you’re in the 25% tax bracket, then take your taxable income multiplied by your tax bracket. For example, take $34,300 multiply by 25%.

Unbeknown to most people, this is not how tax brackets work. You’re actually taxed on a progressive scale. Meaning the first dollar you make, doesn’t have the same tax rate as the last dollar.

Using the same example above as a single filer who has a taxable income of $34,300, you would calculate their tax liability by:

(8,350 – 0) x 10% = $835
(33,950 – 8,350) x 15% = $3,840
(34,300 – 33,950) x 25% = $350
Total Amount Owed = $5,025

(2010 Income Tax Brackets)

After calculating how much tax you owe against your taxable income, you then apply your tax credits, which reduce this figure on a dollar for dollar basis. For example, if you could claim $4,000 in tax credits, instead of owing $5,025 in tax, you would owe $1,025.

The Most Common Tax Credits

Below is an outline of some of the most common tax credits that you may qualify for now or in the future. Click on the links to learn more.


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{ 3 comments… read them below or add one }

Dana @ Budget DietitianNo Gravatar February 7, 2011 at 9:21 am

Gotta love tax credits! My hubby is a CPA which makes my life easier.

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BrianNo Gravatar February 8, 2011 at 7:44 am

Great I know understand tax credits

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RobNo Gravatar February 9, 2011 at 1:13 pm

Thanks, I was having a hard time explaining this to my partner. I sent him a link to this article and I think it’s one of the cleanest explanations I have seen.

Rob

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